Resolving Environmental Issues in a Real Property Transaction

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[This article originally appeared in the Oakland Business Review, June 2013.]

Prices for commercial properties are rising.  Investors are buying commercial properties, malls and strip centers because returns are higher than other investments, such as government bonds.  If you are considering buying or selling property, understanding these three environmental issues can help ensure a profitable transaction.

What is a Phase I and why do I need one?

A Phase I identifies the prior uses of a property and whether hazardous materials may be present.  It includes the review of environmental documents, interviews and a visual inspection of the site and surrounding properties.  A Phase I also includes a title search for liens or environmental restrictions.  A Phase I does not require any environmental sampling or testing.  It is a review of accessible information to determine whether environmental issues might exist.

Lenders frequently require a property owner or a potential buyer to conduct a Phase I as a condition for refinancing or obtaining a loan.  Depending on the availability of financing and the negotiating power of the borrower, a party may have little choice but to conduct a Phase I.  A properly conducted Phase I also is a necessary step to obtain protection against liability under federal and state environmental laws.  Preparing a Phase I can take six weeks or more, so don’t leave this important step until the last minute.

Can the contract allocate environmental risks?

Property owners and buyers are often reluctant to prepare a Phase I because of the concern that the findings may jeopardize the transaction. But, uncovering environmental issues doesn’t mean that a transaction is doomed.  It is almost always more cost effective to understand and address these issues upfront, rather than get dragged into a lawsuit later.

If the parties know or suspect that there is environmental contamination at the property, the responsibility for addressing it can be set out in relevant contracts, including the purchase and sale agreement.  The parties can distribute known or potential environmental liability between them, but the language in the contract must clearly document the intention of the parties.  Courts have shown some reluctance to transfer environmental liability unless the contract cannot reasonably be interpreted in any other manner.  Thus, a provision to transfer environmental liability must be carefully drafted with an eye toward court precedent.  Other options, such as indemnification may also be considered for certain types of risks, however, the parties should fully understand the pros and cons of each approach.

Is environmental insurance coverage available?

What if the parties still have concerns about the environmental risks?  Costs to investigate and remediate environmental contamination are typically excluded from current commercial general liability.  But, environmental coverage is available.  Understanding insurance options and  aggressively negotiating the language of a potential policy can drastically influence the risks and potential rewards of a real estate transaction.

For example, you may have pressed hard in negotiations to require the other party to indemnify you for any future environmental costs.  Contractual provisions, though, can only protect you up to the limit of the other party’s ability to pay.  There’s nothing worse than having a rock-solid indemnity claim against a party that will never be able to pay the resulting judgment.

But, various types of insurance are available.  Coverage can be obtained to protect yourself in the event the party providing the indemnity is unable to pay.  Pollution Legal Liability coverage protects against the possibility that a diligent investigation did not identify contamination that was in fact present.  Cost Cap insurance protects parties against run-away environmental remediation costs. 

The insurance marketplace is constantly evolving and premiums can depend on a number of variables.  In the right situations, an environmental insurance policy can protect against situations that might otherwise have made the deal unprofitable or too risky.  Understanding these and other environmental issues and how to address them is necessary to getting the best deal in any real estate transaction.